EBITDA – What’s it all about?

/in /by Jim Leonhard

EBITDA may seem to be the holy grail of business assessment in the M&A world. Almost every potential buyer starts by asking what is the selling company’s EBITDA; and almost every seller wants to know at what multiple of EBITDA his or her business will sell for.

From an accounting standpoint, EBITDA is a simple concept: Earnings Before Interest, Taxes, Depreciation and Amortization. However, it has also been referred to as “Earnings Before I Trick D’Auditor”. Why would someone characterize it that way? Because, as it turns out, EBITDA may not be such a simple concept. For example:

  • EBITDA is really a “proxy” for “free cash flow” which is difficult to determine from an income statement alone
  • Is the EBITDA as reported or has it been “normalized” or adjusted for discretionary, nonrecurring and nonoperating items?
  • What timeframe was used? Calendar year, fiscal year, long-term average, trailing twelve months, or projected?
  • Are liabilities or forecasted earn-out payments, for example, included in what’s being valued when a multiple is applied to EBITDA?

What else should be considered when relying on EBITDA?

  • EBITDA essentially ignores real cash items such as interest and taxes, as well as changes in working capital that a company needs to fund day-to-day operations
  • While depreciation and amortization are non-cash items, adding them back makes a company appear to have more cash flow than it really does, since capital assets being depreciated will have to be replaced eventually
  • Private Companies can manipulate EBITDA as it is calculated from an income statement that may contain exaggerated income or under-reported expenses.
  • Earnings quality is often overlooked
  • In an actual transaction, the multiple is different for the buyer and seller
  • Despite the concerns above, EBITDA, when properly developed, is still a good method to evaluate and compare profitability. The most efficient and effective operators in an industry will have the highest EBITDA as a percent of sales.

In sum, EBITDA is just a starting point to developing a thorough, clearly-explained and well-supported measure of expected cash flows. It is important to trust business valuation to certified and experienced specialists who understand that it’s just not that simple.